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Three Trading Mistakes Rookies Make (and Why Wall Street Loves It When This Happens)

Trump’s executive order halting enforcement of the Dodd-Frank "fiduciary rule" is a done deal. The rule would have compelled financial advisers to act as fiduciaries, in the best interest of their clients.

Now, the best advisers already do act as fiduciaries, with their clients’ best interests at heart. But of course there are some loose cannons out there who may cost Americans as much as $17 billion a year in blown savings.

The focus on the fiduciary rule takes me back to my days as a trading instructor, when I traveled the country giving seminars and teaching hundreds of thousands of people how to trade options.

In every session, students would tell me stories of conversations with their financial advisers; the advisers would lay horror stories on – thick – to convince them to stay away from "dangerous" options.

The thing is, I recognized these “scary” trades as some of the most lucrative, risk-manageable moves a trader could make! These "advisers," for reasons we’ll see in a minute, were keeping people away from some huge profits.

So, some of my students had been forced to act with incompetent advice, or bad or incomplete information. Naturally, with no one to help, they made some costly mistakes in the process.

Well, I’m going to show you what I showed them: how best to avoid those mistakes and safely capture your profits.

But first we’ll look at the source of the “big scare”…

Why Wall Street Makes Options Sound Frightening

One of the reasons options trading has a bad, scary reputation is because the some financial advisers simply never spent the time to learn how options actually work. In turn, they can't advise their clients on how to trade them successfully.

What they can’t or won’t say is that options are actually vehicles used to mitigate, or hedge, your risk in the stock market.

They allow you to take part in a stock's price movement with significantly less capital, which reduces your risk on the trade. Options, when used the right way, can make you more money on your trades faster (and with less risk) than simply investing in the stock.

The "problem" with options isn't options themselves… it's not knowing how to trade them the right way (or at all).

Now, in order to become an adviser, you've got to pass a series of regulatory financial licensing exams. One of these exams, called the Series 7, includes a small section on options, so exam takers don’t really need to know much about options to pass the test and get licensed.

In fact, a survey conducted by the Financial Planning Association found that some of these fully licensed "advisers" confessed to not really knowing how to invest.

For that one simple reason, these bad-apple advisers won't allow you to trade options, citing their risk. But really, they simply don't know enough about them and don't want to risk losing clients – or, more to the point, their commissions – because they can't explain how to trade options the right way.

And that led their clients to make expensive mistakes like those I’m about to show you. The "advisers" who give this bad advice love it when people make these mistakes because the all-but-inevitable losses make it appear as though their counsel was right all along. To coin a phrase: “Sad!”

Here’s what you need to avoid.

Bad Move No. 1: Buying Out-of-the-Money (OTM) Options

This happens more often to novice traders, but even the seasoned trader can fall back into this mistake. In the case of buying (or going long) a call option, an OTM option is one in which the strike price of the option contract is higher than the stock price. For example, if you buy a $50 call option on a $47 stock, you're "three points OTM."

But why on Earth would you exercise your right to buy a stock at $50 when you can buy it on the open market for $47? It just doesn't make sense from a profits standpoint. Not to mention… if the stock doesn't get higher than the $50 strike price or enough so to offset the cost of that call option, the value of that option could fall to $0 – and you could lose all the money you spent on the trade.

Bad Move No. 2: Buying Options with Extremely Short Expirations

Options are fixed-time investments, meaning they expire. So you need to be able to exercise your right on the option or close the option before it expires. Using our example of a long call, the stock has to move high enough in price, preferably prior to expiration, to offer profits. And if it doesn't, the value of the option can decline, which means you're stuck losing money simply due to the passage of time.

Bad Move No. 3: Trading Options with Zero Liquidity

For options, many people look at the number in the "OI" column. "OI" stands for open interest, which is the number of options that have been bought- or sold-to-open and have yet to be closed (profitably or not). Some may also trade based on volume, which is the number of contracts traded so far during the day.

Now these are great measures of liquidity, but the best measure is the difference between the bid and ask spread. The tighter the spread (or the closer the numbers are), the better the liquidity. The bid is the price at which you can sell the option, and the ask is the price at which you pay for the option. You want to be able to cover the spread as quickly as possible. For example, if an option is quoted at 2.00 x 2.40, then that typically means you're buying the option for $2.40 and can only sell it at the time for $2.00. That's $0.40 difference, or a $40 per contract difference you have to make up ($0.40 x 100 shares from the option contract).

If you believe the stock will move enough to cover that spread, more power to you. But there may be times when the stock moves in the direction you want and the option spread in our example rises to 2.00 x 2.10. This means that that bid/ask spread tightened, but you still can't get more than $2.00 for the option.

Contrast that to an option quoted at 2.00 x 2.05. This is much better because you only need the option to move 0.05 to cover or break even on that $5 difference. Remember, the tighter the spread, the better the liquidity. One way you can track the optionable stocks with high liquidity is to use the penny pilot list from the Chicago Board Options Exchange (CBOE) website.

So, the best way to beat the worst and most incompetent of Wall Street’s "advisers," who are either incapable of or unwilling to serve your best interests, is to educate yourself.

I encourage you to commit to earning while you’re learning with my free Power Profit Trades service. You can sign up below and you’ll start getting lessons in a few days.

I’ll be right here with you each step of the way to show you exactly what to do – and what not to do – as you trade options for risk management and big profits.

This Cash Will Likely Be Gone in 12 Hours (I Need an Answer): On Feb. 2, I gave away $1 million to my readers. The money was gone in four days. On Feb. 6, I gave away another half a million dollars. It was gone in two days. And now, I’m giving away another $500,000. It will likely be gone tomorrow. Be smart and learn how to claim your share now.

To get Tom’s Power Profit Trades twice each week, at no cost, click here.

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About the Author

Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.

With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.

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  1. Dennis | February 14, 2017

    With a put credit spread, What happens as the underlying falss below the Break-Even value?

  2. Jack A | February 16, 2017

    Please explain thoroughly how money can be made on a put option. The price of the stock has to decrease, so do you "sell to close" or some other way.

  3. Randy Nordman | February 17, 2017

    Looking forward to it..have already.experienced the downside of this not knowing the proper mechanics.
    You've already helped, Thank you!

  4. Simen Lourds | February 17, 2017

    Excellent and easy to digest!

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